© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Chapter 2 IS-LM Model...

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier Blanchard

Chapter 2Chapter 2

IS-LM ModelIS-LM Model

Asst. Prof. Dr. Mete FeridunAsst. Prof. Dr. Mete Feridun


The IS-LM ModelThe IS-LM Model

The IS/LM model is a macroeconomic tool that The IS/LM model is a macroeconomic tool that demonstrates the relationship between interest demonstrates the relationship between interest rates and real output in the goods and rates and real output in the goods and services market and the money market. services market and the money market.

The intersection of the IS and LM curves is the The intersection of the IS and LM curves is the "General Equilibrium" where there is "General Equilibrium" where there is simultaneous equilibrium in both markets.simultaneous equilibrium in both markets.

IS/LM stands for Investment Saving / Liquidity IS/LM stands for Investment Saving / Liquidity preference Money supply.preference Money supply.


THE IS (Investment = Savings) CURVE

Inflation and inflationary expectations are assumed to Inflation and inflationary expectations are assumed to be stable.be stable.

The IS curve derives a relationship between interest rates and income in the short run

An increase in the interest rate reduces investment by making it more expensive for firms to borrow money to make investment purchases and also by increasing the opportunity cost for those who plan to finance investment projects using their own funds.


the relationship between Y and r that ensure that the goods market is in equilibrium: spending=production.

Note that when interest rates are high, investment falls and therefore Y must fall as well; the IS curve should show a negative relationship between r and Y .


Deriving the Deriving the ISIS Curve Curve

Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. The IS curve is downward sloping.

The Derivation of the IS The Derivation of the IS CurveCurve


a steep IS curve means that Y does not respond very much to r.

In other words, a change in the real interest rate does not have a significant impact on GDP.


Movements Along the Curve

When interest rates decrease, spending rises and as a result output increases as well. This is reflected in a movement to a lower point on the IS curve where interest rates are lower and output is higher.

Conversely, when interest rates increase, spending falls and as a result output decreases as well. This is reflected in a movement to a higher point on the IS curve where interest rates are higher and output is lower.


Parallel Shifts of the IS Curve

Increases in (1) consumer confidence, (2) investor confidence, (3) government purchases, (4) net exports will raise expenditure, and therefore production of goods and services, shifting the IS curve out (rightwards).

A reduction in lump-sum taxes will increase expenditure on goods and services and therefore increase output as well. This will cause the IS curve to shift out.


Shifts of the Shifts of the ISIS Curve: T & G Curve: T & G

An increase in taxes shifts the IS curve to the left.

Shifts of the IS Shifts of the IS CurveCurve


IS Curve captures the effect of IS Curve captures the effect of nominal interest rate nominal interest rate ii on output Y on output Y, for given values of T and G. (tax and , for given values of T and G. (tax and government purchase).government purchase).

Investment demand depends negative on interest rate. Investment demand depends negative on interest rate. Hence, when Hence, when ii increase, the investment and then the increase, the investment and then the total demand will fall. So will the total output Y.total demand will fall. So will the total output Y.

Therefore, IS curve is downward sloping.Therefore, IS curve is downward sloping.

IS re la tio n: Y C Y T I Y i G( ) ( , )

The Goods MarketThe Goods Marketand the and the ISIS Relation Relation


We derived the IS curve, the first part of the model of economic fluctuations known as the IS-LM model. The IS Curve summarized all the combinations of interest rates and GDP that clear the market for goods and services in the economy.

The IS curve by itself cannot give us the value of output in the economy because it does not have anything to say about the level of interest rates in the economy.

Hence we need to derive the LM curve and study its intersection with the IS curve.


Financial Markets and Financial Markets and the LM (Liquidity Preference = Money Demand) curve

LM curve is a relationship that describes the behavior of the money market, which determines interest rates in the economy.

The LM curve consists of the combinations of income and interest rates that clear the market for money balances (i.e. equate money demand and money supply).

The interest rate is determined by the equality of the supply of and the demand for The interest rate is determined by the equality of the supply of and the demand for money:money:

M Y L i $ ( )

MM = nominal money stock = nominal money stock$YL$YL((ii) = demand for money) = demand for money$Y$Y = nominal income = nominal incomeii = nominal interest rate = nominal interest rate


Real Money, Real Income,Real Money, Real Income,and the Interest Rateand the Interest Rate

The The LMLM relation relation: In equilibrium, the real money supply is equal to the real money demand, : In equilibrium, the real money supply is equal to the real money demand, which depends on real income, Y, and the interest rate, Iwhich depends on real income, Y, and the interest rate, I

(Why? Because higher i implies a higher (Why? Because higher i implies a higher Opp. CostOpp. Cost of holding money). of holding money).

LM Curve captures the effect of output Y on nominal interest rate i, for given values of M (nominal money supply) and P (in short run price is assumed to be fixed).


When r is high, the demand for money is low because money pays no interest – the opportunity cost of holding money instead of other financial assets rises.

When Y is high the demand for money is high, richer people who buy more goods are likely to hold more money.

When prices P are high the demand for money is high since people need more money to complete their transactions.

Higher total output implies higher transaction demand. So for given level of nominal money supply, high demand implies the interest rate that clear the money market has to increase. So when Y increases, the nominal interest rate i increases.

Therefore, LM curve is upward sloping.


Deriving the Deriving the LMLM Curve Curve

An increase in income leads, at a given interest rate, to an increase in the demand for money. Given the money supply, this leads to an increase in the equilibrium interest rate.

The Effects of an The Effects of an Increase in Income on Increase in Income on the Interest Ratethe Interest Rate


Deriving the Deriving the LMLM Curve Curve

Equilibrium in financial markets implies that an increase in income leads to an increase in the interest rate. The LM curve is upward-sloping.

The Derivation of the The Derivation of the LM CurveLM Curve


MOVEMENTS ALONG THE LM CURVE

Changes in money demand brought about by changes in Y or by changes in r are reflected as movements along the LM curve.

When income decreases, money demand falls and as a result interest rates must decrease to restore money market equilibrium.

When income increases, money demand rises and as a result interest rates must increase to restore money market equilibrium.


If the CB increases the money supply (expansionary monetary policy) then from the equation we can see that the vertical (r) intercept will be lower and the horizontal (Y) intercept will be larger, i.e. the LM curve shifts out (to the right).

An increase in the price level has the same effect as a decrease in the money supply - it shifts the LM curve in (to the left).

An increase in exogenous money demand raises the vertical intercept and makes the horizontal intercept smaller: the LM curve shifts in (to the left).


The basic intuition is that the movement of interest rates depends on the relationship between money demand and money supply.

Exogenous changes that bring about excess money demand, i.e. drive money demand above money supply, cause interest rates to rise in order to lower money demand and equilibrate money demand and supply. The LM curve will shift in.

These changes include a fall in money supply, a rise in prices or an increase in exogenous money demand.

Exogenous changes that bring about excess money supply, i.e. drive money supply above money demand cause interest rates to fall in order to raise money demand and equilibrate money demand and supply. The LM curve will shift out.

These changes include an increase in money supply, a fall in prices or a decrease in exogenous money demand.


An increase in the supply of money by the CB will result in an excess supply of money.

This will cause the LM curve to shift outwards in order to restore equilibrium.

An increase in the price level will raise money demand and result in an excess demand for money.

This will cause the LM curve to shift inwards to restore equilibrium


Another way of intuitively understanding the LM curve is as follows.

When there is an excess supply of money, people are more likely to put the extra money into non monetary financial assets, so issuers of those assets can offer lower rates of interest yet still attract buyers.

Conversely, when there is an excess demand for money, people are less likely to put money into non monetary financial assets, so issuers of those assets must offer higher rates of interest to attract buyers.


Shifts of the Shifts of the LMLM Curve: M Curve: M

An increase in money leads the LM curve to shift down.

Shifts of the LM Shifts of the LM CurveCurve


IS-LM model

It is a short run model of the determination of output.

The model has two main parts: an IS curve that summarizes all the combinations of Y and r consistent with goods market equilibrium and an LM curve that summarizes all the combinations of Y and r that are consistent with money market equilibrium.

Since the IS curve summarizes all combinations of income and interest rates that clear the market for goods and services while the LM curve summarizes all combinations of income and interest rates that clear the money market, equilibrium income and the equilibrium interest rate are at the intersection of the two curves.


Putting the Putting the ISIS and the and theLMLM Relations Together Relations Together

Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output.

Equilibrium in financial markets implies that an increase in output leads to an increase in the interest rate.

When the IS curve intersects the LM curve, both goods and financial markets are in equilibrium.

The IS-LM ModelThe IS-LM Model


Anywhere other than the intersection we would expect there to be changes in Y or r that restore either goods market or money market equilibrium.

Generally, we believe that the money market adjusts very quickly so the economy will rarely be off the LM curve. However, it will not stay off the IS curve for very long either as firms can adjust production to bring it in line with demand.


Fiscal Policy, Activity,Fiscal Policy, Activity,and the Interest Rateand the Interest Rate

Fiscal contractionFiscal contraction, or , or fiscal consolidationfiscal consolidation, , refers to fiscal policy that reduces the budget refers to fiscal policy that reduces the budget deficit.deficit.

An increase in the deficit is called a An increase in the deficit is called a fiscal fiscal expansionexpansion..

Taxes affect the Taxes affect the ISIS curve, not the curve, not the LMLM curve. curve.


Fiscal Policy, Activity,Fiscal Policy, Activity,and the Interest Rateand the Interest Rate

An increase in taxes shifts the IS curve to the left, and leads to a decrease in the equilibrium level of output and the equilibrium interest rate.

The Effects of an The Effects of an Increase in TaxesIncrease in Taxes


Monetary Policy, Activity,Monetary Policy, Activity,and the Interest Rateand the Interest Rate

Monetary contractionMonetary contraction, or , or monetary monetary tightening,tightening, refers to a decrease in the money refers to a decrease in the money supply.supply.

An increase in the money supply is called An increase in the money supply is called monetary expansionmonetary expansion..

Monetary policy does not affect the Monetary policy does not affect the ISIS curve, curve, only the only the LMLM curve. For example, an increase curve. For example, an increase in the money supply shifts the in the money supply shifts the LMLM curve down. curve down.


Monetary Policy, Activity,Monetary Policy, Activity,and the Interest Rateand the Interest Rate

Monetary expansion leads to higher output and a lower interest rate.

The Effects of a The Effects of a Monetary ExpansionMonetary Expansion


Using a Policy MixUsing a Policy Mix

The combination of monetary and fiscal polices is The combination of monetary and fiscal polices is known as the known as the monetary-fiscal policy mix,monetary-fiscal policy mix, or simply, or simply, the the policy mix.policy mix.

The Effects of Fiscal and Monetary Policy.

Shift of ISShift of ISShift of Shift of

LMLMMovement of Movement of

OutputOutputMovement in Movement in Interest RateInterest Rate

Increase in taxes left none down down

Decrease in taxes right none up up

Increase in spending right none up up

Decrease in spending left none down down

Increase in money none down up down

Decrease in money none up down up


The Clinton-Greenspan Policy MixThe Clinton-Greenspan Policy Mix

Selected Macro Variables for the United States, 1991-1998

19911991 19921992 19931993 19941994 19951995 19961996 19971997 19981998

Budget surplus (% of GDP) (minus sign = deficit)

3.3 4.5 3.8 2.7 2.4 1.4 0.3 0.8

GDP growth (%) 0.9 2.7 2.3 3.4 2.0 2.7 3.9 3.7

Interest rate (%) 7.3 5.5 3.7 3.3 5.0 5.6 5.2 4.8


The Clinton-Greenspan Policy MixThe Clinton-Greenspan Policy Mix

The appropriate combination of deficit reduction and monetary expansion can achieve a reduction in the deficit without adverse effects on output.

Deficit Reduction and Deficit Reduction and Monetary ExpansionMonetary Expansion


German Unification and the German German Unification and the German Monetary-Fiscal Tug of WarMonetary-Fiscal Tug of War

Table 5-2 Selected Macro Variables for West Germany, 1988-1991

19911991 19921992 19931993 19941994

GDP growth (%) 3.7 3.8 4.5 3.1

Investment growth (%) 5.9 8.5 10.5 6.7

Budget surplus (% of GDP) (minus sign = deficit)

2.1 0.2 1.8 2.9

Interest rate (%) 4.3 7.1 8.5 9.2


German Unification and the German German Unification and the German Monetary-Fiscal Tug of WarMonetary-Fiscal Tug of War

The Monetary-Fiscal The Monetary-Fiscal Policy Mix of Post-Policy Mix of Post-Unification GermanyUnification Germany


Effects of Monetary and Fiscal Effects of Monetary and Fiscal Policy in the IS/LM ModelPolicy in the IS/LM Model

Fiscal PolicyFiscal Policy Expansionary fiscal policy shifts the IS curve Expansionary fiscal policy shifts the IS curve

to the rightto the right Contractionary fiscal policy shifts the IS curve Contractionary fiscal policy shifts the IS curve

to the leftto the left

Monetary PolicyMonetary Policy Expansionary monetary policy shifts the LM Expansionary monetary policy shifts the LM

curve to the rightcurve to the right Contractionary monetary policy shifts the LM Contractionary monetary policy shifts the LM

curve to the leftcurve to the left


Fiscal Policy and Crowding OutFiscal Policy and Crowding Out

When government expenditures increase, When government expenditures increase, output and income begin to increase.output and income begin to increase.

The increase in income increases the The increase in income increases the demand for money.demand for money.

The increase in money demand increases The increase in money demand increases the interest rate.the interest rate.

Higher interest rates cause a decrease in Higher interest rates cause a decrease in investment, offsetting some of the investment, offsetting some of the expansionary effect of the increase in expansionary effect of the increase in government spending.government spending.


Partial Crowding OutPartial Crowding Out1. Let’s assume if government spending increases by $500, IS increases by $1000.

$6600

IS0

LM

Rea

l In

tere

st R

ate

(%)

Aggregate Output

IS1

$1000

4%

$6000

5%

$7000

2. The increase in incomeincreases money demandwhich increases interestrates from 4% to 5%.

3. The increase in the interestrate causes a decrease in investment so that the increasein income is only $600, less thatthe full multiplier effect.


Full Crowding OutFull Crowding Out1. Again government spending increases by $500, and the IS increases by $1000. 2. If the demand for money

is totally insensitive to the interest rate, the interest rateincreases from 4% to 9%.

3. The increase in the interestrate causes a decrease in investment that completely offsetsthe increase in government spending.

IS0

LM

Rea

l In

tere

st R

ate

(%)

Aggregate Output

IS1

$1000

4%

$6000

9%

$7000


Ineffective Fiscal PolicyIneffective Fiscal Policy

When complete crowding out occurs, When complete crowding out occurs, fiscal policy is ineffective, changing only fiscal policy is ineffective, changing only interest rates, not output.interest rates, not output.

Crowding out is greater if:Crowding out is greater if: Money demand is very sensitive to Money demand is very sensitive to incomeincome

changes changes Money demand is not very sensitive to Money demand is not very sensitive to interest interest

raterate changes changes


Monetary Policy in the IS/LM ModelMonetary Policy in the IS/LM Model

In a liquidity trap, increases in the money supply do not decrease interest rates, so investment and output do not increase.

The CB increases the money supply which decreases interest rates and increases investment and output.

Y1

IS

LM0

Rea

l In

tere

st R

ate

(%)

Aggregate Output

Y0

r0

r1

LM1

IS

LM0

Rea

l In

tere

st R

ate

(%)

Aggregate OutputY0

r0

LM1


Ineffective Monetary PolicyIneffective Monetary Policy

Investment is not sensitive to the interest Investment is not sensitive to the interest raterate If investment does not respond to interest rate If investment does not respond to interest rate

changes (the IS curve is steep), monetary changes (the IS curve is steep), monetary policy in ineffective in changing output.policy in ineffective in changing output.

Liquidity trapLiquidity trap If increases in the money supply fail to lower If increases in the money supply fail to lower

interest rates, monetary policy is ineffective in interest rates, monetary policy is ineffective in increasing output.increasing output.


Short-Run Outcomes of PolicyShort-Run Outcomes of Policy


Examples of Monetary and Fiscal Examples of Monetary and Fiscal PoliciesPolicies


Anticipation of Policy ProblemsAnticipation of Policy Problems

The IS/LM model does not take into account the The IS/LM model does not take into account the effect of people’s expectations of policy actions.effect of people’s expectations of policy actions.

If investors expect the Fed to increase the money If investors expect the Fed to increase the money supply and decrease interest rates, they will buy supply and decrease interest rates, they will buy bonds now.bonds now.

The increase in demand for bonds increases their The increase in demand for bonds increases their price and decreases interest rates price and decreases interest rates beforebefore the money the money supply is actually increased.supply is actually increased.


Monetary Policy Tools and Credit Monetary Policy Tools and Credit Condition ProblemsCondition Problems

The IS/LM model assumes that interest The IS/LM model assumes that interest rates are the only determinant of rates are the only determinant of investment.investment.

Investment also depends on Investment also depends on credit credit conditionsconditions, the willingness of banks to , the willingness of banks to lend independent of interest rates.lend independent of interest rates.

If banks raise their lending standards, If banks raise their lending standards, investment may not respond to investment may not respond to expansionary monetary policy.expansionary monetary policy.


Implementation Problems of Implementation Problems of Monetary and Fiscal PolicyMonetary and Fiscal Policy

Uncertainty about Potential Uncertainty about Potential OutputOutput

Information LagInformation Lag

Policy Implementation LagPolicy Implementation Lag


Uncertainty About Potential OutputUncertainty About Potential Output

One macroeconomic policy goal is to keep One macroeconomic policy goal is to keep output as close to potential as possible.output as close to potential as possible.

In the real world, economists aren’t sure In the real world, economists aren’t sure what potential output is.what potential output is.

If policymakers use contractionary policy If policymakers use contractionary policy when the economy is actually below when the economy is actually below potential, they create unemployment.potential, they create unemployment.

Using expansionary policy above potential Using expansionary policy above potential output will cause inflation.output will cause inflation.


Information LagInformation Lag

The IS/LM model assumes that The IS/LM model assumes that policymakers see what is happening in the policymakers see what is happening in the economy and can instantly alter policies economy and can instantly alter policies to fix any problem.to fix any problem.

In the real world there is an In the real world there is an information information laglag, a delay between a change in the , a delay between a change in the economy and knowledge of that change.economy and knowledge of that change.


Policy Implementation LagPolicy Implementation Lag

The The policy implementation lagpolicy implementation lag is the delay between the is the delay between the time policymakers recognize the need for a policy action time policymakers recognize the need for a policy action and when the policy is instituted.and when the policy is instituted.

Fiscal policy has a large implementation lag because Fiscal policy has a large implementation lag because policy must be formulated and legislation passed by policy must be formulated and legislation passed by Congress and the President.Congress and the President.

Monetary policy has a shorter implementation lag Monetary policy has a shorter implementation lag because the Federal Open Market Committee decides because the Federal Open Market Committee decides monetary policy. monetary policy.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Chapter 2 IS-LM Model...

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